Handle With Care

A guide to buying toxic assets.

What are your true feelings about America and its dream of home ownership? Do you believe it will survive the economic meltdown? Do you think most people will keep paying their mortgages and not walk out on their homes?

If so, you might want to join me in buying mortgage-backed securities, commonly lumped into that odious investment category known as “toxic assets.” Years ago, on Wall Street, I helped create these securities with computer software (which I described in “My Manhattan Project”). Now, I farm oysters out in Long Island. But like a lot of people, I’m always on the lookout for a good investment opportunity. And for a few months now, I’ve been thinking that the economic panic has been overblown and that, if you look carefully, bargains can be found in toxic waste.

I’m hardly the only one—with the hand-holding of the Treasury Department, two large companies have recently started buying them as part of the once-ballyhooed Public-Private Investment Program. The difference is, I’m proceeding without a taxpayer safety net, so I have to be extremely cautious.

When I was on Wall Street, the bonds that I worked on were based on a model that had proven infallible over 40 years—it projected that home prices would rise steadily at 5 percent a year and that no more than one percent of homeowners would default on their mortgages. With these assumptions, you could buy almost any slice of a mortgage-backed bond, even a really risky slice that paid you an elevated rate of return, and expect to make your money back and then some.

Well, those days are history, as we all know. Many holders of mortgage-backed bonds have been wiped out. But it is the nature of economies that one person’s distress presents somebody else with an opportunity, and so I am wading into the toxic sludge. My conviction is simple: Betting against America has been a losing proposition. We are, after all, the only country in the world that has always made timely payments on its debt. Considering the oceans of stimuli being poured into the system, is there any way that streak won’t continue? If the country remains solvent, so will the vast majority of its homeowners.

I have no illusions about the risk of what I’m doing. Buying mortgage-backed bonds today is putting your finger to the wind in a storm, like you're standing on a seawall facing a nor'easter. You know the second wave of defaults is coming. It's forming out past Montauk, swelling in Gardiners Bay, about to smash into your seawall. Will it knock you down, rip your boat from its cleats, and scatter your oyster cages all along the rock pile?

More Americans are going to lose their homes, but how many? How bad will it end up being? How bad is where the trade is.

I buy my bonds through a former colleague named T. He and I started together in mortgage research at Lehman in 1988. He went into trading in 1990, then into institutional sales. He was one of the few lifers I knew. After twenty years at Lehman, he retired, six months before the firm disintegrated.

T. went through a period of mourning for Lehman. Retired, he tried to buy homes in foreclosure with the goal of fixing them up and renting them. But prices were 60 to 70 cents on the dollar, while he knew that collateralized mortgage obligations, the first lien on real estate, were trading much, much cheaper. He thought he saw “arb,” a price discrepancy that could be exploited for profit. Because house prices hadn’t fallen as much as institutional investors had feared, that meant the bonds were underpriced. T. rejoined many of his ex-Lehman colleagues at a major investment bank and set about buying bonds.

"I gave up on stocks: One goes up, one goes down, who knows why," T. tells me. “I only invest in real estate, what I know. So if the stock market has rallied by 50 percent, corporates and munis are way up this year, why are CMOs still dropping? I'd rather buy the lien on a house at 15 than pay 65 for the foreclosed home from the bank." (By 15 and 65, he means cents on the dollar.)

Five trillion dollars of existing CMOs are out there, each one slightly different than the others. Their value depends on the quality of the underlying home mortgages and how they’re structured. Once upon a time, investors relied on the rating agencies to tell them which bonds were safe to buy. Now that the ratings have been discredited, you have to treat every bond like a time bomb, carefully assessing how much time you’ve got before it blows up in your face.